Latin America faces third shock as global financial conditions tighten

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As Latin American countries continue to grapple with the effects of two previous shocks, the pandemic and Russia’s invasion of Ukraine, they face a third shock: tighter global financial conditions.

Growth momentum is currently positive, reflecting the return of service sectors and employment to pre-pandemic levels, and overall support from favorable external conditions – high commodity prices, strong external demand and remittances. , and rebound in tourism. This has led to several upward revisions to growth this year.

But funding is becoming increasingly scarce and expensive as major central banks raise interest rates to keep inflation under control. Capital inflows to emerging markets are slowing and external borrowing costs are rising. Emerging market domestic interest rates are also rising as their central banks are also raising rates to fight inflation, but also due to reduced investor appetite for risky assets.

For Latin America, these factors translate into a deceleration in activity, as rising borrowing costs weigh on domestic credit, private consumption and investment.

Earlier this year, soaring commodity prices and strong growth momentum helped offset the effects of tighter global financial conditions, as investors were drawn to a region that hosts major commodity exporters amid a global food and energy needs. But higher interest rates drive down commodity prices as the global economy slows, reducing their dampening effect. The slowdown could also reduce exports, remittances and tourism in the region.

Uncertainty about global interest rates and the possibility of gently controlling inflation (a so-called “soft landing”) means that spikes in volatility and investor risk aversion are also possible. In other words, the transition to higher global interest rates could be bumpy.

Solid growth but deceleration

Amid positive surprises in activity, we raised our growth projection for Latin America and the Caribbean this year to 3.5%, from 3% in July.

But with the shifting winds ahead, growth next year is poised to slow faster than we expected in July, slowing to 1.7%.

Commodity exporters – countries in South America, Mexico and some Caribbean economies – are likely to see their growth rates halve next year as falling commodity prices amplify the impact of rising interest rate.

The economies of Central America, Panama and the Dominican Republic will also slow due to weaker trade with the United States and inward remittances, although they will benefit from lower commodity prices. Caribbean economies dependent on tourism will continue to recover, albeit more slowly than expected in July amid weaker tourism prospects.

Fight stubborn inflation

Despite slowing growth, Latin America will continue to face high inflation for some time.

The rapid response of the region’s major central banks, which raised interest rates ahead of other emerging and advanced economies, will help lower inflation, but this will take time as monetary policy needs to rein in domestic demand to put downward pressure on prices.

In addition, price pressures have recently intensified, affecting items in the consumption baskets other than food and energy. This has been the case in Brazil, Chile, Colombia, Mexico and Peru, where inflation recently hit a two-decade high of 10% and is testing the hard-won credibility of targeting frameworks. inflation.

We have therefore raised our inflation forecasts. Price increases for these five countries will reach around 7.8% by the end of the year and will remain high at around 4.9%, still above central bank tolerance bands in most cases, by the end of next year.

Healthy banks, debt risks

Rising global interest rates will also test the resilience of private and public balance sheets. The region’s generally sound banking systems mitigate the risk of financial distress, and regulation and supervision have improved in many countries.

But pockets of vulnerabilities remain. For example, corporate debt has increased dramatically over the past decade, especially outside the banking system. Monitoring these vulnerabilities will be key to identifying potential sources of stress and taking early action.

While the region’s high levels of international reserves and strong central bank credibility will help cushion the impact of tighter financial conditions, rising borrowing costs will strain public finances through higher interest payments as public debt and financing needs remain high.

Balance

Central banks in the region acted quickly and kept long-term inflation expectations anchored.

Going forward, monetary policy should stay the course and not ease prematurely. Setting monetary policy in an environment of high uncertainty is difficult, but having to restore price stability later if inflation takes hold would be very costly.

Fiscal policy should focus on rebuilding political space where needed. This will require controlling public spending, improving the design of tax systems and strengthening fiscal frameworks to ensure sustainable discipline.

However, given the dire social needs in the region, debt and deficit reduction policies can only be effective and sustainable if they are inclusive, that is, if they protect the poor.

Even where there is fiscal space, fiscal policy should also go hand in hand with monetary policy, focusing on supporting vulnerable groups, especially as long as high inflation persists and growth weakens. , but without fueling domestic demand. This will require careful calibration to offset spending measures aimed at protecting the poor.

Getting this balancing act right is essential to achieving inclusive and sustainable growth, and it is the best way to build resilience to future shocks.

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